Some companies, particularly monoline insurance companies (i.e., insurers that insure against one type of risk), seek to maintain a large contingent source of capital (sometimes referred to as “soft capital”) in order to maintain or achieve a high credit rating from credit rating agencies. The large contingent source of capital provides assurance that adverse events (such as a catastrophe leading to higher or increased claims for an insurer) would not impair the company's ability to meet its obligations. Especially for highly leveraged companies that depend on continuous efficient access to the capital markets, such as monoline insurance companies, maintaining elevated credit ratings is critical. However, to maximize return on assets and profitability, companies typically do not want such contingent capital sources to be on their balance sheets until needed. To achieve their goals, companies have obtained standby letters of credit from banks or have issued auction-rate preferred securities.
FIG. 1 is a diagram of a financing involving auction-rate preferred securities. In this structure, an operating company 10 establishes a trust 12. The trust 12 issues the auction-rate preferred securities 13 to investors 14. Auction-rate preferred (ARP) securities are fixed-income instruments (such as trust preferred securities) that pay a periodic payment (e.g., a dividend or coupon) to the holders thereof. ARP securities are typically priced in a Dutch auction by prospective investors. The rate of the payment is reset each auction, which is typically every twenty-eight days, to reflect changes in market conditions. With the proceeds from the offering of the ARP securities, the trust 12 purchases eligible assets 16, which are typically thirty-day commercial paper and/or short-term government securities.
In addition, so as to reduce interest rate risk and ensure access to the full amount of the assets, the trust 12 enters into an asset swap agreement with an asset swap counterparty 17. Under the asset swap agreement, the trust 12 pays the asset swap counterparty 17 interest paid on the eligible assets 16, and the asset swap counterparty 17 makes investment decisions relating to the eligible assets 16 and pays a floating rate payment to the trust 12 that is related to a published index rate, such as LIBOR. The asset swap counterparty 17 also guarantees that the par value will be received on termination.
Because the eligible assets 16 are short-term, the trust 12 must obtain new eligible assets periodically (e.g., every thirty days). Because the yield on the eligible assets 16 may fluctuate from one period to the next, the payment rate on the ARP securities 13 must also be periodically adjusted.
The trust 12 also enters into a put option with the operating company 10. Under the put option, the operating company 10, at its option, may require the trust 12 to purchase shares of stock in the operating company 10. Typically the shares are perpetual preferred stock. The purchase price is the par value of the eligible assets 16. In exchange for this right, the operating company 10 pays a put premium (typically periodically) to the trust 12. The trust 12 uses the proceeds from the put premium and the floating rate payments from the asset swap counterparty 17 to make the payments on the ARP securities 13 to the investors 14.
Further, the put right may also be exercised by an affiliate company 18 (typically a subsidiary) of the operating company 10 exercising an unconditional right to withdraw the eligible assets 16 in exchange for delivering shares of perpetual preferred stock of the operating company 10 to the trust 12. In the event that the market value of the eligible assets 16 is less than their original value at inception (sometime referred to as “par value” herein), the trust 12 also receives a termination payment from the asset swap counterparty 17 for the difference and the trust 12 forwards that payment to the affiliate company 18 (the trust 12 makes such a payment to the asset swap counterparty 17 if the market value exceeds par value). This constitutes the contingent source of capital (soft capital) for the company. The affiliate company 18 may withdraw the assets to pay large claims in the event of a catastrophe, for example. Because the affiliate company 18 has unconditional access to the full par value of the eligible assets 16, credit rating agencies will typically consider the operating company 10 and the affiliate company 18 to own the assets for credit purposes. In such an arrangement, however, the investors 14 face the potential risk (though typically very small) that the operating company 10 or the affiliate company 18 will withdraw some or all of the eligible assets 16 and replace them with perpetual preference shares of the operating company 10.
There are drawbacks for companies that use this financing structure. For example, the ARP securities 13 have to be auctioned to prospective investors periodically (e.g., every 28 days). If there is low investor demand for such securities, the interest rate necessary to sell a sufficient amount of the securities may be high, requiring a large put premium from the operating company 10 to make up the difference. This may reduce the attractiveness of the ARP securities-based contingent capital arrangement. Stand-by letters of credit are also becoming increasingly difficult to obtain.